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Paris - Signs are growing that Europe's economic and
monetary union may be fragmenting faster than policymakers can repair it.

Eurozone leaders agreed in principle on June 29 to establish
a joint banking supervisor for the 17-nation single currency area, based on the
European Central Bank (ECB), although most of the crucial details remain to be
worked out.

The proposal was a tentative first step towards a European
banking union that could eventually feature a joint deposit guarantee and a
bank resolution fund, to prevent bank runs or collapses sending shock waves
around the continent.

The leaders agreed that the eurozone's permanent bailout
fund, the €500bn European Stability Mechanism, would be able to inject capital
directly into banks on strict conditions once the joint supervisor is
established.

But the rush to put first elements of such a system in place
by next year may come too late.

Deposit flight from Spanish banks has been gaining pace and
it is not clear a eurozone agreement to lend Madrid up to €100bns in rescue
funds will reverse the flows if investors fear Spain may face a full sovereign
bailout.

Many banks are reorganising, or being forced to reorganise,
along national lines, accentuating a deepening north-south divide within the
currency bloc.

An invisible financial wall, potentially as dangerous as the
Iron Curtain that once divided eastern and western Europe, is slowly going up
inside the euro area.

The interest rate gap between north European creditor
countries such as Germany and the Netherlands, whose borrowing costs are at an
all-time low, and southern debtor countries like Spain and Italy, where bond yields
have risen to near pre-euro levels, threatens to entrench a lasting divergence.

Since government credit ratings and bond yields effectively
set a floor for the borrowing costs of banks and businesses in their
jurisdiction, the best-managed Spanish or Italian banks or companies have to
pay far more for loans, if they can get them, than their worst-managed German
or Dutch peers.

Political backlash

The longer that situation goes on, the less chance there is
of a recovery in southern Europe and the bigger will grow the wealth gap
between north and south.

With ever-higher unemployment and poverty levels in southern
countries, a political backlash, already fierce in Greece and seething in Spain
and Italy, seems inexorable.

ECB president Mario Draghi acknowledged as he cut interest
rates last week that the north-south disconnect was making it more difficult to
un a single monetary policy.

Two huge injections of cheap three-year loans into the
eurozone banking system this year, amounting to €1 trillion, bought only a few
months' respite.

"It is not clear that there are measures that can be
effective in a highly fragmented area," Draghi told journalists.

Conservative German economists led by Hans-Werner Sinn, head
of the Ifo institute, are warning of dire consequences for Germany from
ballooning claims via the ECB's system for settling payments among national
central banks, known as TARGET2.

If a southern country were to default or leave the euro,
they contend, Germany would be left with an astronomical bill, far beyond its
theoretical limit of €211bn liability for eurozone bailout funds.

As long as European monetary union is permanent and
irreversible, such cross-border claims and capital flows within the currency
area should not matter any more than money moving between Texas and California
does.

But even the faintest prospect of a Day of Reckoning changes
that calculus radically.

In that case, money would flood into German assets
considered "safe" and out of securities and deposits in countries
seen as at risk of leaving the monetary union. Some pessimists reckon we are
already witnessing the early signs of such a process.

Overwhelming?

Any event that makes a euro exit by Greece - the most
heavily indebted member state, which is off track on its second bailout
programme and in the fifth year of a recession - look more likely seems bound
to accelerate those flows, despite repeated statements by EU leaders that
Greece is a unique case.

"If it does occur, a crisis will propagate itself
through the TARGET payments system of the European System of Central
Banks," US economist Peter Garber, now a global strategist with Deutsche
Bank, wrote in a prophetic 1999 research paper.

Either member governments would always be willing to let
their national central banks give unlimited credit to each other, in which case
a collapse would be impossible, or they might be unwilling to provide boundless
credit, "and this will set the parameters for the dynamics of
collapse", Garber warned.

"The problem is that at the time of a sovereign debt
crisis, large portions of a national balance sheet may suddenly flee to the
ECB's books, possibly overwhelming the capacity of a bailout fund to absorb the
entire hit," he wrote in 2010, after the start of the Greek crisis, in a
report for Deutsche Bank.

European officials tend to roll their eyes at such theories,
insisting the euro is forever, so the issue does not arise.

In practice, national regulators in some EU countries are
moving quietly to try to reduce their home banks' exposure to such an
eventuality. The ECB itself last week set a limit on the amount of state-backed
bank bonds that banks could use as collateral in its lending operations.

In one high-profile case, Germany's financial regulator
Bafin ordered HypoVereinsbank (HVB), the German subsidiary of UniCredit, to
curb transfers to its parent bank in Italy last year, people familiar with the
case said.

Such restrictions are legal, since bank supervision is at
national level, but they run counter to the principle of the free movement of
capital in the EU's single market and to an integrated currency union.

Whether a single eurozone banking supervisor would be able
to overrule those curbs is one of the many uncertainties left by the summit
deal. In any case, common supervision without joint deposit insurance may be
insufficient to reverse capital flight.

German Chancellor Angela Merkel, keen to shield her grumpy
taxpayers, has so far rejected any sharing of liability for guaranteeing bank
deposits or winding up failed banks.

Veteran EU watchers say political determination to make the
single currency irreversible will drive eurozone leaders to give birth to a
full banking union, and the decision to create a joint supervisor effectively
got them pregnant.

But for now, Europe's financial disintegration seems to be
moving faster than the forces of financial integration.

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